This paper empirically investigates transmission effects of U. S. and Japanese monetary policy on Korean Economy using vector error correction model. Theories predict that US or Japanese monetary expansion can have either positive transmission effects on Korean economy depending on the relative size of the expenditure and exchange rate effects. The key findings in this study are as follows. First, most macroeconomic monthly data series of Korea, the U.S. and Japan used in this study are found to be non-stationary. This finding suggests that traditional regression analysis of monetary transmission mechanism, using non-stationary series, should be subject to invalid inference tests and spurious regression problems. Second, the devaluation of the nominal exchange rate against the Japanese yen does not have long-run effects due to price adjustment processes but the real devaluation does have an expansionary effect on Korea's real output through the improvement of its international competitiveness. Finally, an expansionary U.S. monetary policy is found to have short-run positive effect but no long-run effect on Korea's real output, implying that the expenditure effect dominates the exchange rate effect in the short run. This suggests that a U.S. contractive monetary policy can have short-run perverse transmission impacts on the Korean economy and a decrease in the two countries' real money balance have unfavorable long-run effects. This may give Korean monetary authority an incentive to offset the negative transmission effects even under the floating exchange rate regime.

This paper empirically investigates transmission effects of U. S. and Japanese monetary policy on Korean Economy using vector error correction model. Theories predict that US or Japanese monetary expansion can have either positive transmission effects on Korean economy depending on the relative size of the expenditure and exchange rate effects. The key findings in this study are as follows. First, most macroeconomic monthly data series of Korea, the U.S. and Japan used in this study are found to be non-stationary. This finding suggests that traditional regression analysis of monetary transmission mechanism, using non-stationary series, should be subject to invalid inference tests and spurious regression problems. Second, the devaluation of the nominal exchange rate against the Japanese yen does not have long-run effects due to price adjustment processes but the real devaluation does have an expansionary effect on Korea's real output through the improvement of its international competitiveness. Finally, an expansionary U.S. monetary policy is found to have short-run positive effect but no long-run effect on Korea's real output, implying that the expenditure effect dominates the exchange rate effect in the short run. This suggests that a U.S. contractive monetary policy can have short-run perverse transmission impacts on the Korean economy and a decrease in the two countries' real money balance have unfavorable long-run effects. This may give Korean monetary authority an incentive to offset the negative transmission effects even under the floating exchange rate regime.

Monetary Policy, Transmissions Mechanism, Vector Error Correction Model, Dynamic OLS, Perron Unit Root Test.